David Curtis says pension funds can take risk off the table without damaging their ability to access returns
‘Return of Fear' read a recent newspaper headline, referring to the sudden spike of global market volatility during the first few months of this year. Against a backdrop of heightened turbulence, it is no surprise that pension trustees and their advisers seem to be revisiting their approach to risk.
Traditionally the preserve of matching asset portfolios, de-risking strategies have been put to good use by trustees, who have been proactive in removing interest rate and inflation risk via liability-driven investment (LDI).
Given that asset allocation in portfolios is typically structured on a risk versus reward basis, the extension of de-risking to portfolios' growth segment can prompt queries about the fate of rewards.
Certainly, in today's environment, opportunities for risk-free reward are few and far between, but there is something to be said for a more holistic approach to risk. Rather than segmenting exposures in terms of matching or growth portfolios, we encourage trustees to consider the scale and concentration of risk at the whole portfolio level.
Relative to interest rate and inflation risk, the risks intrinsic to growth assets - particularly equities - now seem disproportionately high in many schemes. The average UK scheme has a 30% allocation to equities, but this segment comprises nearly 85% of portfolios' total risk exposure (Pension Protection Fund Purple Book 2016).
Market volatility so far this year has brought equity risk into focus for many fiduciaries and, as we emerge from a ‘QE world', the outlook for equity markets looks increasingly challenged - with valuations unilaterally high across major markets. An increasing number of schemes are therefore assessing ways to dial down this exposure - whether through a shift in asset allocation or the addition of an investment strategy.
Diversification is crucial to this next de-risking step; numerous funds have ventured into alternative assets in their bid to de-risk their equity exposure and diversify, but an increasing number are accessing new drivers of returns known as ‘risk premia'.
Risk premia provide schemes with a liquid, transparent and - relative to hedge funds - cost-effective way to diversify growth assets. Risk premia is nothing new, however; equity, in and of itself, carries a risk premia provided for bearing entrepreneurial risk. Holders of equity are rewarded for committing their capital at risk, either with capital return or via dividend income; by expanding into alternative risk premia, investors can extend their scope of access to a diversified set of return drivers.
Risk premia can be harvested using a range of factors, among others, value, momentum and carry. Value provides exposure to undervalued assets which tend to outperform relative to more expensive peers, momentum exploits the tendency for recent relative price movements to continue into the future, while carry capitalizes on the trend for higher-yielding assets to outperform lower-yielding assets.
Broadly, we believe that approaches to risk premia should be highly diversified and target as many styles and asset classes as possible. It is generally easier to implement these approaches with a portfolio construction which stays neutral to the overall equity market, given the breadth and depth of markets and scope of opportunities. That said, advanced execution capabilities remain key to minimising market friction and harvesting risk premia in the most efficient way.
By adopting an efficient approach to diversification across their growth assets, pension funds can take risk off the table without damaging their ability to access returns.
David Curtis is head of UK and Ireland institutional business at Goldman Sachs Asset Management
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